Why Buying Small Cap Stocks Makes Sense Right Now

CONTRIBUTOR Martin Tillier

When legendary analyst Bob Farrell’s “10 Market Rules to Remember” was published, the first rule was that “markets return to the mean over time.” Farrell was talking about markets overall and was essentially warning investors not to overreact to short term moves, up or down. It does not, as some people seem to think, apply to individual stocks. Stocks can and do fall to zero should a company go bankrupt, so a stock that has underperformed won’t always revert to the mean.

However, the principle can be applied to sector and style analysis of stocks. If, say, industrials have tracked the overall market over the long-term in annual return but have been underperforming for a year or two, a period of overperformance can be anticipated as the sector reverts to its mean. Similarly, if growth stocks outperform value for a while there will probably be a time when the opposite will be true as the relative performance of the two reverts to its long-term average relationship.

That same principle can be applied to differences in companies’ size, small cap versus large cap for example, and on that basis, small cap stocks are due a period of strength. They have underperformed for a while, but over time, they outperform large cap, and that relationship will be restored at some point in time.

Given that advisors are fond of saying that small cap stocks are much riskier than the stock of larger companies, it usually surprises investors to find out that, over long periods, small cap funds outperform their large cap counterparts. When you think about it though, it does make sense. By “risky”, advisors mean volatile, and that cuts both ways. Yes, small cap stocks tend to lose more ground when the market is falling but they also gain more when it is rising. So, given that stocks go up over time, the gains in small cap over extended periods are generally larger.

That can be seen if we look at a chart for the SPDR ETF that tracks the small cap Russell 2000 index (IWM) since its inception in May of 2000 (the green line on the chart below) versus the large cap Dow tracker (DIA).

That shows a gain in IWM of 302% in that time versus 255% for DIA. The 2-year chart for the same two funds, however, tells a different story, with IWM having lost 5% while DIA gained 11%.

There are legitimate reasons for that. Most notably, a rising rate environment hurts small cap stocks more than large cap. Small companies typically carry more debt than do large cap and don’t usually have big cash holdings that can benefit from higher interest rates, so weakness as rates rise is to be expected. What doesn’t fit, however, is that small cap stocks have remained relatively weak over the last few months, when overall market strength is based on an expectation of rate cuts sometime this year.

Logically, a reversion to the mean is coming, and if so, small cap stocks will have to gain enough to not only catch up with large cap, but also to pass them and reestablish their relative outperformance. The question, of course, as it always is with trading and investing, is when that will happen. It is a question that nobody can honestly answer with any degree of confidence, but now seems like as good a time as any to start positioning your portfolio for when it does happen.

Even if the Fed continues to try to dampen expectations as they have been this week, that will mainly impact the large cap stocks that have gained the most from those expectations. Small caps, on the other hand, have been where traders and investors have priced in their doubts about a policy shift, so they should react less on a comparative basis. That doesn’t mean that you won’t show losses on small cap holdings if the market turns, but it does make it likely that those losses will be smaller than they would be in large cap stocks. If the market is right, though, and for all the Fed’s cautious talk they do cut rates later this year, small caps will have some serious catching up to do and will post significant gains.

The principle of reversion to the mean indicates that small cap stocks will have their day before too long. We are in an unusual place right now, with all the good news priced into large cap and all the risk priced into smaller companies’ stocks, creating a situation where small caps have both a reduced downside and an increased upside potential. All trading and investing involve risk, and buying small caps here is no exception, but the current unique set of circumstances make it look like a risk worth taking.